In Pandora’s Valuation, a Few Sour Notes

Pandora Media is distinctly Web 2.0. Its Music Genome Project tailors Internet radio stations to individual tastes. Pandora is using that digital DNA to capitalize on investor demand for hot technology plays, with an initial public offering that could value the company at $1.4 billion. But investors should be going in with their eyes, and not just their ears, wide open. Pandora’s business model is pretty old school.

It might look like a rival to Sirius XM, the satellite radio monopoly. But Pandora’s primary competition is in the analog dashboard of terrestrial radio. Pandora generated almost 90 percent of its $138 million of revenue in the year through Jan. 31 from advertising. Sirius’s coin comes from 20 million paying subscribers.

Pandora also does not have the financial scalability of a Facebook or the network-effect stickiness of an OpenTable, the online reservations system. The more people who listen, the more royalties the company pays for music. Total operating expenses move up nearly in lockstep with sales.

The company is growing in popularity. Registered users have quadrupled to 94 million in two years. Advertisers cannot help noticing. By 2014, some $17 billion will be spent on American radio spots, the market research firm IDC forecasts. Snatching a mere 3 percent of that would nearly quintuple Pandora’s existing revenue.

But that might not be so easy. Though AM/FM radio’s popularity is waning, listeners still tune in for more than two hours a day, according to Bridge Ratings. By contrast, based on Pandora’s figures, its users log in on average for considerably less time. That could take some shine off Pandora’s ability to aim ads more precisely.

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A Pandora worker monitoring new music. The service is not yet profitable.Credit
Peter Dasilva for The New York Times

It also means that despite Pandora’s impressive growth, its valuation looks exuberant. Sirius trades on an enterprise value of about 3.8 times estimated 2011 revenue, according to Thomson One Analytics. The terrestrial operator Cumulus bought a rival, Citadel, earlier this year for about 3.2 times revenue. If you split the difference and generously assume Pandora’s top line doubles again this year, the company would be worth less than the low end of its I.P.O. price range. And that still overlooks the lack of any profit after six years.

Bullish on Japan

Bond traders have been betting against Japanese government bonds for years — and losing spectacularly. Victims of the so-called widow-maker trade of shorting the bonds thought the March disaster would vindicate them. Rebuilding will add to Japan’s sky-high debt and, with a shrinking work force and rising pension costs, push up yields. But the quake has not disrupted the self-perpetuating money machine that drives the bonds. Doomsayers still run the risk of becoming road kill.

The bonds have outperformed United States and German bonds over the last five years, returning over 55 percent in dollar terms, according to Merrill Lynch, despite yielding less than 2 percent. Much of that is a function of the yen’s appreciation against the dollar. But short-sellers have also been flummoxed by the surprising way that a government with debt twice the size of its economy has managed not just to avoid a Greek-style blowout, but also to borrow more cheaply every year.

All but 5 percent of Japanese government bonds are held by Japanese, not foreigners demanding attractive yields. Japanese who balked at low yields and invested elsewhere have been punished. At home, stocks have halved since 2005 and the yen’s climb has sapped gains offshore.

Japan’s pension funds and insurers accumulate long-term bonds to match their liabilities. Banks are the largest buyers by far, a fact unlikely to change unless the economy revs up. With growth anemic and prices falling, companies are paying off loans and socking cash into bank accounts rather than investing it. With worthy borrowers scarce, banks park these deposits in government debt.

Even if Japan’s economy does miraculously revive, inflation and growth would offset higher borrowing costs by increasing tax revenue. The real concern, then, is whether demographics might derail the Japanese bond engine. As the work force shrinks and the ranks of retirees grow, pension funds might need to sell their holdings. The government’s funding needs would then rise as income taxes decline.

Even without fiscal reforms, though, Japan is not likely to reach this tipping point for at least five years, sufficient time to get its fiscal house in order and avert a crisis. True, Japan’s politicians demonstrate a paucity of leadership to tackle these problems. But that is still enough of a window to make a few more widows out of those betting against Japanese government debt.

For more independent financial commentary and analysis, visit www.breakingviews.com.

A version of this article appears in print on June 6, 2011, on page B2 of the New York edition with the headline: Listen Carefully For the Sour Notes. Order Reprints|Today's Paper|Subscribe